If you know what an IRA is and already have one, good for you! You are ahead of the majority of the population, considering only 36% of US households owned IRAs as of mid-2019. If you do not know what an IRA is, it is an Individual Retirement Account. It is essentially a tax-advantaged savings plan that comes in two main flavors – Traditional IRAs and Roth IRAs.
Basically, an IRA is like any brokerage account you might have on Robinhood or TD Ameritrade, but the tax benefits allow you to grow your savings more quickly than in a taxable account, or not have to pay taxes when you withdraw which can amount to huge savings for your nest egg!
First let’s look at the difference between a Traditional IRA and a Roth IRA:
Traditional IRA – you can contribute using pre-tax income and then pay taxes on withdrawals later. This type of IRA is beneficial for those who make a lot of income today and will likely make less income in retirement. If you are in this boat, which is the case for the majority of people, the benefit comes from the fact that by contributing pre-tax income, you can invest more into the market and generate compounded growth from a larger base, and pay less in taxes because when you make distributions as you retire, you will probably fall into a lower tax bracket now than where you are now.
Roth IRA – you contribute using after-tax income and then do not have to pay any taxes when you withdraw. This type of IRA is more beneficial to those who are not making as much income today, and therefore fall in a lower tax bracket. You would get taxed upfront on your earnings, hopefully at a lower tax rate today than what you would experience when you retire.
However, these tax benefits come at a cost. The government is forgoing some tax income so that Americans can have more saved for retirement, but they cannot allow you to put all of your money into an IRA or else they would not be able to collect any taxes from capital gains.
Therefore, there are certain stipulations associated with IRAs:
Now there are also big differences regarding early withdrawals:
For Traditional IRAs, there are a number of ways to avoid the 10% early withdrawal penalty such as using the withdrawn money to pay for qualified higher education expenses, qualified first time home-buyer expenses, medical expenses that are not reimbursed by health insurance, and more.
For Roth IRAs, you can withdraw any amount of money you contributed at any time without having to pay a penalty or taxes, but you cannot withdraw any earnings before the age of 59 ½ without paying the 10% early withdrawal penalty except in a few instances. These are that you must have had the Roth IRA for at least five years AND have a permanent disability, die and the money is withdrawn by your beneficiary or estate, or use the money (up to $10,000) for a first-time home purchase.
To really put this in perspective, imagine Sally put $6,000 of after-tax income into her Roth IRA today. Then in a year her account value grows 10% to $6,600. She can withdraw her original $6,000 at any time but cannot withdraw any of the $600 of earnings without paying the 10% penalty. This means if she wanted to withdraw all of the money from her Roth IRA, she would get back $6,540 (still probably better than paying taxes on the $600 of earnings). Because of this provision, the Roth IRA offers increased flexibility in case of the worst. However, Sally will never be able to put back in the $6,000+ that was contributed in 2019. She can still put in $6,000 for next year’s contribution but will never be able to add money retroactively. This is why starting early is so beneficial, once a year passes, you will never be able to go back and contribute for that year!
To further harp on this point, let’s look at two scenarios. Historically, the stock market has returned about 10% annually, but to be conservative let’s use 7%.
If Tom starts his Roth IRA at the age of 20 and consistently invests $6,000 until he is 60, with continuous compounding at a 7% annual rate of return, Tom will have $1,287,657 for retirement.
Sally on the other hand started contributing at the age of 30, simply ten years later than Tom, and ends up with $612,438, about half of what Tom has for retirement.
In total, Tom put in $6,000 for 40 years equating to $240,000, meaning with $1,287,657, he multiplied his contribution by 5.37x. The first $6,000 he put in at the age of 20 grew into $89,847, increasing by a factor of 15x!
Sally however put in $6,000 for 30 years equating to $180,000, meaning with $612,438 at the age of 60, Sally multiplied her total contribution by only 3.4x The first $6,000 she put in at the age of 30 grew into $45,674, increasing by a factor of 7.61x.
This means that Tom had each dollar he first contributed increase to $15, while Sally’s only increased to $7.61. Tom’s first dollar increased by almost double what Sally’s first dollar increased by, by simply starting his IRA and contributing 10 years earlier when he was 20 instead of 30.
This effect is further propounded the longer you leave your money in, same as the earlier you start. Just for fun, say both Tom and Sally decided to start a Traditional IRA and left in their money until the maximum age when distributions become required at 70 (70 ½ actually).
If Tom starts at the age of 20, he will have over $2.6M! A pretty solid nest egg if you ask me.
Conversely, Sally will have $1.3M, which is still great! (But not nearly as cushy as Tom)
The best part of all of this is that if it is a Roth IRA, you can withdraw your millions TAX FREE! If it is a Traditional IRA, you would have put in the money TAX FREE and then hopefully when you retire somewhere between age 50-70 you will be in a lower tax bracket of say 18% instead of 35%, which makes a huge difference when you are talking about this much money!
How to Open an IRA
So by now you must be wondering how to open an account! Pretty much any institutional financial firm offers the ability to open an IRA such as Fidelity, Charles Schwab, TD Ameritrade, Wells Fargo, Betterment, Vanguard, etc. I choose to use Vanguard because I find them easy to use, and I buy Vanguard products anyways in my IRA so there are no fees. Best of all, Vanguard offers some of the lowest expense ratios (which is the annual fee they charge for creating and running their mutual funds or ETFs) which in the long run may matter.
I choose to hold most of my IRA money in VOO which is a Vanguard ETF that tracks the S&P500 which is a market-weighted fund with exposure to the largest 500 companies in the US (although there are actually 505 companies in the S&P500). The S&P500 is generally used as a proxy to represent the US economy and VOO has the smallest expense ratio that I have come across at 0.03% which is really next to nothing. That’s 3 cents for every $100 invested each year. Historically, investing in the US economy has been a solid bet, here is a snippet of the market’s performance.
Allocation wise, many would argue that everyone’s portfolio should include some bonds for safety, even if it is just 10%. To achieve that goal, Vanguard also has a broad bond market ETF with the ticker BND. I choose to also hold some VFTAX which is the ticker for one of Vanguard’s social index funds to invest in socially responsible companies (it just so happens that the fund is beating the S&P500). While I tout broad market ETFs, the beauty of an IRA is that you can invest in virtually any asset you want – bonds, CDs, individual stocks, mutual funds, ETFs, etc. However, before you go dump all your retirement money into Tesla, I would read about the skewedness effect which is why most active managers cannot even come close to passive management.
In summary, you basically want to pay minimal taxes to maximize the returns on your investments for in the wise words of Benjamin Franklin, “In this world nothing can be said to be certain, except death and taxes”. You should therefore choose which type of IRA is best for you – Traditional or Roth, invest your money prudently and consistently, and do not touch it until you retire. In this way, you will have a nice nest egg and can mitigate both evils by minimizing taxes so that you can enjoy retirement.
With this newfound knowledge, I wish all of you finance warriors the best of luck!